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ECON 209 Chapter 25.docx

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Economics (Arts)
ECON 209
Paul Dickinson

ECON 209 February 14, 2013 Chapter 25 – The Difference Between Short-Run and Long-Run Macroeconomics 25.1 Two Examples from Recent History Inflation and Interest Rates in Canada: The Bank of Canada’s 1990s policy to reduce inflation:  Higher inflation pushes up interest rates; lower inflation drives them back down (b/c inflation erodes the val of money and lenders need to be compensated)  To reduce inflation, the Bank had to reduce the growth rate of money, tightening up credit market conditions and driving up interest rates… HOW AN A POLICY THAT DRIVES UP INTEREST RATES REDUCE INFLATION?  You have to understand the different short-run and long-run effects of monetary policy  Short-run reduction in the liquidity of money  scarcer credit  rising real and nominal interest rates  firm investment and private big-ticket consumption decline  reduction in real GDP  unemployment rate rises  econ enters a recession  A monetary policy designed to reduce inflation is usually effective precisely b/c it creates a temporary recession  Recession  wages and other factor prices begin to adjust  econ starts to approach its new long-run equilibrium  wages start to increase at slower rate than before/may even fall (i.e. wage growth declines due to excess supply of labour)  pressure on prices to rise declines  inflation falls  nominal interest rates fall  In the long run, money is neutral, b/c changes in the money supply have no long-run effect on real variables (e.g. GDP, employment, and investment), but do have an effect on nominal variables (e.g. price level or rate of inflation)  A.k.a. changes in the money supply do not change the level of potential output (Y*)  In the short run, money is not neutral, b/c changes in the money supply affect real variables  A.k.a. (in the short run) monetary policy shifts the AD curve and generates short-run changes in real GDP Saving and Growth in Japan:  In the 1990s, Japan’s economy grew very little – this was largely due to “too much” saving (not enough activity to stimulate the econ)… BUT high saving was also a primary reason for Japan’s econ success (growth) over the previous 40 yrs… HOW?  In the short run, w/ factor prices and tech more or less constant, an increase in households’ desire to save implies a reduction in expenditure  reduction in output  AD curve shifts left  real GDP falls  econ slump  In the long run, after wages and prices adjust to the recessionary gap, greater saving  larger pool of financial capital  interest rate is driven down  increased investment  econ converges on a higher level of potential output in the long run  Countries w/ high long-run investment rates tend to be countries w/ high rates of long-run per capita GDP growth  Nat’l income in the short run is largely demand determined  Nat’l income in the long run is largely supply determined A Need to Think Differently:  Short-run changes in GDP must be viewed as deviations of output from potential output  Long-run changes in GDP must be viewed as changes in the level of potential output 25.2 Accounting for Changes in GDP The val of potential GDP is estimated by combining 3 pieces of info: 1. The amts of available factors of production 2. An estimate of these factors’ “normal” rates of utilization 3. An estimate of each factor’s productivity Changes in GDP:  Short-run changes in GDP primarily involve the opening and then closing of an output gap  Long-run changes in GDP involve changes in potential GDP, w/ little of no change in the output gap  Output is determined in the short run by the AD and AS curves  Output is determined in the long run only by the level of Y* GDP Accounting – The Basic Principle: We can break down GDP into its component parts  GDP = GDP  GDP = F × (GDP/F)  F is econ’s total available stock of factors  GDP = F × (FE/F) × (GDP/F )E  F Es the number of the econ’s factors that are employed **NOTE: It is not actually possible to add labour, land, and capital together to get F, b/c different factors are measured in different units… however, we do so for simplicity’s sake  F is the econ’s factor supply (total amt of factors of production that the econ currently possesses)  FE/F is the factor utilization rate (the fraction of total supply of factors that is actually used or employed at any given time)  GDP/F iE a simple measure of productivity b/c it shows the amt of output (GDP) per unit of input employed (F E  Any change in GDP can be decomposed into a change in factor supply, a change in factor utilization, and a
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